As noted earlier, there are a number of investment strategies in which an investor borrows funds to purchase securities. The investor’s expectation is that the return earned by investing in the securities purchased with the borrowed funds will exceed the borrowing cost.The use of borrowed funds to obtain greater exposure to an asset than is possible by using only cash is called leveraging. In certain circumstances,a borrower of funds via a repo transaction can generate an arbitrage opportunity. This occurs when it is possible to borrow funds at a lower rate than the rate that can be earned by reinvesting those funds.
Time Series Plot of the Federal Funds Rate and Overnight Repo Rate
Such opportunities present themselves when a portfolio includes securities that are “on special” and the manager can reinvest at a rate higher than the repo rate. For example, suppose that a manager has securities that are “on special” in the portfolio, Bond X, that lenders of funds are willing to take as collateral for two weeks charging a repo rate of say 3%. Suppose further that the manager can invest the funds in a 2-week Treasury bill (the maturity date being the same as the term of therepo) and earn 4%. Assuming that the repo is properly structured so that there is no credit risk, then the manager has locked in a spread of 100 basis points for two weeks. This is a pure arbitrage and the managerfaces no risk. Of course, the manager is exposed to the risk that Bond X may decline in value but this the manager is exposed to this risk anyway as long as the manager intends to hold the security.
The Bank of England has conducted a study examining the relationship between cash prices and repo rates for bonds that have traded special.The results of the study suggest a positive correlation between changes in a bond trading expensive to the yield curve and changes in the degree to which it trades special. This result is not surprising. Traders maintain short positions in bonds which have associated funding costs only if the anticipated fall in the bond’s is large enough to engender a profit. The causality could run in either direction. For example, suppose a bond is perceived as being expensive relative to the yield curve. This circumstance creates a greater demand for short positions and hence a greater demand for the bonds in the repo market to cover the short positions.Alternatively, suppose a bond goes on special in the repo market forw hatever reason. The bond would appreciate in price in the cash market as traders close out their short positions which are now too expensive to maintain. Moreover, traders and investors would try to buy the bond outright since it now would be relatively cheap to finance in the repo market.
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Global Money Markets Tutorial
Money Market Calculations
U.s. Treasury Bills
Corporate Obligations:commercial Paper Andmedium-term Notes
Debt Obligations Offinancial Institutions
Repurchase And Reverse Repurchase Agreements
Short-term Mortgage-backed Securities
Short-term Asset-backed Securities
Futures And Forward Rate Agreements
Swaps And Caps/floors
Asset And Liability Management
Bank Regulatory Capital
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